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Checklist for the sale or acquisition of a closely-held company

by AccountingWeb on Jun 29 2007printer friendly

All sales and acquisitions of closely-held companies share a general sequence of activity from inception to consummation. Phases of the process will invariably differ from transaction to transaction, but there is usually a substantial commonality of approach. Although each aspect warrants comprehensive discussion, the following is a checklist and general summary of the most material aspects warranting attention.

1. Targeting the Prospective Suitor: The best method for targeting a prospect will depend on the size of the transaction, the nature of the industry and whether the courtship will be conducted through one-to-one communications or a bid/auction approach.

Contact Local Competitors: All business persons know the identities of their closest competitors and can initiate contact on their own and without outside assistance other than perhaps legal counsel. Although the protection of confidential information is more difficult in dealing with competitors, they often represent the most appealing suitor in that the transaction will not only facilitate cost savings and synergies but may also eliminate some of the more damaging effects of competition.

Contact Strategic Prospects: Sometimes the best suitors are companies engaged in similar business operations in a different region. Such a company might either wish to expand territorially (and hence be a suitable buyer) or pursue an exit strategy for its owners (and hence be a suitable seller). Similarly, companies engaged in related businesses may open vertical integration possibilities and also be attractive.

Contact Business Brokers or Investment Banking Advisors: Brokers and/or investment banking advisors can often locate prospective suitors from their own contacts and undertakings or can locate and/or form interested investment groups. They can also assist in preparing, evaluating and disseminating the transaction information (usually in the form of a confidential placement memoranda) and, if appropriate, in conducting a bid and auction process to narrow the field.

2. Purchase Price Evaluations

Compilation of Financial Information: Financial statements and federal income tax returns for the last three to five years should be reviewed and the information "adjusted" and/or "weighted" to more properly reflect future operations:

Valuation: There is usually no "magic" correct value but rather an appropriate range of values dependent upon the "fit" of buyer and seller and the realism of the assumptions utilized in the valuation methodology. Also, consideration should be given to internal expressions of valuation (eg., buy-sell agreements, insurance arrangements, and deferred compensation and noncompetition agreements).

3. Price Adjustments: Despite agreement as to basic value, ancillary price adjustments may become appropriate in various circumstances.

Taxable vs. Nontaxable Transaction: Transactions which can be structured (all or in part) to exclude or defer current income taxation (eg., tax free reorganizations under Code §368); sale of "small business stock" under §1252; like-kind exchanges under Code §1031; installment sales under Code §453.

Fixed Price vs. Current: A higher price may be justified if the purchase price provides for a partial earnout, since the ultimate uncertainties to the buyer and/or the impact of post-sale events will then be known rather than merely forecast. However, a cash payment approach may present greater practical risk to the buyer with respect to the enforceability of warranties, restrictive covenants, etc.

Cash vs. Deferred Payment: Often the inherent certainty represented in a cash payment (with its elimination of complex credit controls, securities arrangements and remaining credit risks as well as the impact of market interest rate fluctuations and/or other post-sale events and the advantage of liquidity (for alternative investment) may justify a reduction in the acceptable price.

Payment in Stock: Often a payment in stock may offer such ready "currency" for the buyer that it will be prompted to pay a higher price. In addition, it may be appealing to the seller in that it may allow the sale to be accomplished without current taxation. However, unless the stock received is marketable, the seller may be locked into an even less flexible and illiquid situation. Therefore, careful consideration should be given to whether the stock of the buyer is tradeable, subject to a securities law restriction or a contractual lock-in obligation, etc.

Purchase Price Tax Allocations and Tiered Payments: The true after-tax cost (to the buyer) or benefit (to the seller) of a purchase price payment is determined by its tax "character". From the buyer's perspective, a payment that is fully and currently tax deductible is less costly to the buyer, and a payment that is subject to being taxable as a capital gain rather than ordinary income or is subject to single taxation (rather than double taxation at both the entity and owner tiers) is more beneficial to the seller. Various techniques may allow the parties to either optimize their respective positions or negotiate an acceptable middle ground.

Impact of Payroll Taxes and FICA Benefits: To the extent that a portion of the consideration is characterized as being paid in the form of employment compensation, consulting fees, deferred compensation and/or compensation for restrictive covenants, attention should be given to the resulting cost of FICA and other payroll taxation of such payments as well as their potential impact on the recipient's entitlement to Social Security and/or other retirement benefit payments. Thoughtful planning may minimize such tax impact.

Price Adjustments for Tax Attribute Carryovers: Subject to the limitations of Code §382, 283 and 284, the availability of a net operating loss carryover may justify an enhancement of the purchase price.

Post-Sale Transition Services: Whether post-sale employment or consultation services are required by the buyer, or desired by the seller, they may impact on the amount and character of the price paid and should be carefully coordinated with retirement plan and/or Social Security issues.

4. The Negotiating Process

Coordination of Team: Lawyer, accountant, broker/advisor and businessman - each has a part to play, but must be coordinated by a team leader.

Establish Negotiation Objectives and Parameters: The objectives (whether concerning price, personnel, method of payment or other concerns) should be understood from inception, so that all strategic discussions are focused on the ultimate and subordinate goals.

Confidentiality and Noncompetition Agreement: Negotiations should not proceed much beyond the initial contact stage unless and until the parties reach agreement not to misuse confidential information nor raid valued employees or customers in the event that the transaction is not ultimately consummated.

Stayed Information Release: Confidential information that could impair competitive operations in the event the transaction is not ultimately consummated should be withheld until a definitive agreement is reached, which is conditioned upon disclosure and compliance with representations. For example, disclosure as to the volume of Company's customers may be provided early on, but without their identities being provided until later on.

Non-Communication With Employees, Customers, Suppliers, Etc.: Efforts should be taken to insulate potentially concerned relationships until the transaction has become unconditional.

Exclusivity: Often a potential suitor will require that it be the exclusive target or suitor during a brief exploratory/negotiation period before agreeing to invest the required energy and cost to the negotiation process.

5. Due Diligence

Books and Records: Review and confirmation of ownership records and authorization for the proposed transaction.

Tangible Assets: Inspection of physical plant and equipment to confirm good operating conditions and/or to evaluate the state of inventory and work-in-process.

Overall Operations: Analyze quality and pre-sale performance of key employees and other personnel as well as supply and distribution structures and whether bound by long-term contract or are merely at-will arrangements.

Customers/Suppliers: Evaluate (even without specific identities) the number, region, nature and permanence of the seller's customer base and whether bound by long-term contract or are merely at-will arrangements and to what extent produced by a personal workforce or by internet/technological arrangements.

Environmental Compliance: Usually at least a "phase one" inspection and compliance should be obtained as well as preliminary assessment and site investigation to obtain "innocent purchaser" status under applicable acts and/or a "status of non-applicability".

Employees: Review should be made of employee relationships (particularly compensation and benefit terms) and whether they are subject to long-term agreement or at-will arrangements and whether there is a willingness to remain after a change of control and a determination made whether to condition the transaction SO AS to guarantee the ongoing stability of the workforce.

Receivables: The quality and payment history of receivables should be carefully evaluated to assess quality of the revenue base.

Lien Searches: UCC-1 and realty, lien and bankruptcy searches made and good standing certificates obtained.

Warranty Declarations: Although usually a part of the documentation process, requests for warranties are more useful to uncover problems in advance of closing than to create indemnification claims after closing -- eg., good, marketable title free of liens and encumbrances; compliance with all contracts and laws; confirmation of solvency; transaction will not violate any other agreement, etc.

6. Financing Arrangements: Consideration should be given to the availability of internal resources vs. bank loans vs. purchase money financing, since this will materially impact on the desired form of purchase price payment (viz., cash vs. stock vs. installment sale vs. merger, etc.)

7. Possible Required Filings and/or Appraisals

Bulk Sale Filings: Commercial or tax bulk sale state filings may be required in advance of closing.

Antitrust Filings: The relative size of a transaction in the marketplace may require federal filings (eg., Hart Scott Rodino filings).

Required Licensing: Businesses subject to governmental licensing must obtain advance approval for the business transfer.

Commercial/Creditor Approvals: Approvals of leases and/or other contractual commitments must be obtained in advance of closing.

8. Formulate Sale/Purchase Proposal:

Letter of Intent/Term Sheet: Often a non-binding proposal is presented to elicit interest and is followed by a signed Letter of Intent or Term Sheet (which could be nonbinding, binding or binding only as to confidential information and nonsolicitation covenants) after tentative agreement is reached for the purpose of holding the deal together until "definitive agreements" are drafted and signed.

9. Definitive Agreement: The issues raised by this aspect are too numerous and complex to be set forth in this general article and will be addressed in a later issue of the Flaster/Greenberg M & A Report.

10. The Reporting Requirements: Code §1060 requires reporting to the IRS on Form 8594 as to the allocations of the transaction purchase price under the "residual method" -- (viz., essentially allocating first to the fair market value of all assets, whether specified or not in the agreement, and the balance to goodwill and going concern value) as well as the amount of any noncompete payments made to owner/employees.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.